Synergy in Mergers Acquisitions Theory and Practice in

Synergy in Mergers & Acquisitions Theory and Practice in Central Europe October 24 2002 CESP, VŠE in Prague Marek JINDRA, M. A. October 24 2002 Synergy in Mergers & Acquisitions

Content Overview M&As as an Economic Phenomenon n Reasons and Impetus of M&As n Synergy – a Quest for Holy Grail n Synergy Drivers n Value Estimation in M&A Decision Making – technical issues n Central European M&As – a case study n October 24 2002 Synergy in Mergers & Acquisitions 2

Mergers & Acquisitions as an Economic Phenomenon n n Trillion dollar business Rapid increase in volume Multinational dimension A way how to expand rapidly L Monopoly L Value Destruction L More Qs than answers October 24 2002 Synergy in Mergers & Acquisitions 3

Mergers & Acquisitions as an Economic Phenomenon – cont’d Empirical evidence on M&A over last decades: The majority of the studies report that there has been a significant proportion of M&A failures over last five decades since the waves of mergers (MAE grounds) started Actual success rate varies but ballpark figure could be ca. 50% However, some studies are very alarming: 1) Millman and Grey show that “… 83% of mergers produce no benefit whatsoever to shareholders” 2) Sirower finds 60 -70% of acquisitions failing to produce positive returns. October 24 2002 Synergy in Mergers & Acquisitions 4

Mergers & Acquisitions as an Economic Phenomenon – cont’d 1) 2) 3) 4) Change in character of M&As over time: From cost-saving to revenue-increasing Increasing average $ value per transaction whole 1980 s – 35, 000 TA @ total $3 trillion 2000 – 20, 000 TA @ total $3, 3 trillion From domestic to cross-border M&As in 1990 s Mean of payment changes in waves according to MAE conditions October 24 2002 Synergy in Mergers & Acquisitions 5

Reasons and Impetus of M&As - A strategic way how to expand the business and create a value for shareholders - A way for management how to extend its influence, thus compensation – „empire building“ (Transaction Theory - Williamson) October 24 2002 Synergy in Mergers & Acquisitions 6

Reasons and Impetus of M&As – cont’d Theoretical explanations for M&A activity outcomes: 1) Synergy Theory – expects that there is really “something out there” which enables the merged entity to create shareholders value 2) Managerialism Theory – claims that these combinations are driven by empire building not by shareholders wealth objective 3) Managerial Hubris – while following the SWO managers make unconscious mistakes being overconfident about transportability of their successfulness 4) COMParable Ac. Quisitions – legal issue; shareholders of target are protected by the law, while acquirer’s shareholders are not October 24 2002 Synergy in Mergers & Acquisitions 7

Synergy – a Quest for Holy Grail WHAT IS IT? Popular definition: 1 + 1 = 3 Roundabout definition: If am I willing to pay 6 for the business market-valued at 5 there has to be the Synergy justifying that More technical definition: Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities October 24 2002 Synergy in Mergers & Acquisitions 8

Synergy – a Quest for Holy Grail WHAT IS IT? – cont’d Mathematically: Synergy = Economically: n Ability to further limit competitors’ ability to contest their or the targets’ current input markets, processes, or output markets, and/or n Ability to open markets and/or encroach on their competitors’ markets where these competitors cannot respond. October 24 2002 Synergy in Mergers & Acquisitions 9

Synergy – a Quest for Holy Grail SIROWER: “Suppose you are running at 3 mph, but are required to run 4 mph next year and 5 mph the year after. Synergy would mean running even harder than this expectation while competitors supply a head wind. Paying a premium for synergy – that is, for the right to run harder – is like putting on a heavy pack. Meanwhile, the more you delay running harder, the higher the incline is set. This is the acquisition game. ” Not understanding the essentials may be described as (Stern): “Paying unjustified premiums is tantamount to making charitable contributions to random passers-by, never to be recouped by the buying company no matter how long the acquisition is held. ” October 24 2002 Synergy in Mergers & Acquisitions 10

Synergy – a Quest for Holy Grail Lessons from history: • Quaker Oats bought in 1994 Snapple for $ 1, 7 bn. $ 500 mil. lost on announcement, $ 100 mil. a year later Snapple was spun off 2 years later at 20% of price • Anheuser-Busch bought in 1982 Campbell-Taggart at $ 560 mil closed down after 13 y of struggling for survival • IBM bought Lotus for $ 3, 2 bn. (more than 100% premium) probably never to be recouped October 24 2002 Synergy in Mergers & Acquisitions 11

Drivers of Synergy INITIAL FACTORS INTERNAL FACTORS Method of Payment Operations Strategic Relatedness System Integration Control and Culture Contested vs. Uncontested SYNERGY Acquisition Premium Strategy Relative Size Managerial Risk Taking Time October 24 2002 Synergy in Mergers & Acquisitions 12

Strategic relatedness unrelated - strategic Acquisition cross-sector related horizontal complementary competitive vertical October 24 2002 Synergy in Mergers & Acquisitions 13

Strategic relatedness – cont’d Cross-selling Customer-based A B Geographically-based A ? Customers of A-company B ? Customers of B-company same territory distinct groups of customers => cross-sector acquisition Area operated by A-company Area operated by B-company different territory similar groups of customers => horizontal-complementary acquisition X for horizontal-competitive: same territory, same group of customers October 24 2002 Synergy in Mergers & Acquisitions 14

Strategic relatedness – cont’d • Loral corporation & Lockheed. Martin (Mc. Donnel. Douglas switched to Raytheon) • Chevron & Texaco • First Union Corp. & Money Store subsidiary • Conseco & Green Tree Financial Corp. • First Union Corp. & Wheat First October 24 2002 Synergy in Mergers & Acquisitions 15

Mergers vs. Tender offers and Contested vs. Uncontested deals • mergers vs. tender offer • contested vs. uncontested • white knights phenomenon • compared to friendly and hostile bidders resp. • benefits payoff scheme is even more skewed to target’s shareholders • WK lose significantly more than subsequent hostile bidders October 24 2002 Synergy in Mergers & Acquisitions 16

Method of payment Cash vs. stocks • asymmetric information and market’s rational reaction stock-financed transactions punished • waves of stock purchases, related to the MAE situation and market’s mood • stock purchase looks to be something “free” BUT on well-working markets it is NOT October 24 2002 Synergy in Mergers & Acquisitions 17

Relative size • how to measure it? MV, turnover, employees, … => directly comparable only horizontal M&A • empirical evidence proves to be right only for massive differences in size • no strong support for difference in sizes to be significant DEFENSIVE MERGERS October 24 2002 Synergy in Mergers & Acquisitions 18

Internal Factors • Strategy • Operations • System Integration • Control and Culture October 24 2002 Synergy in Mergers & Acquisitions 19

Strategy • Vision AT&T’s vision for the NCR acquisition “to link people, organizations and their information in a seamless global computer network” Viacom’s vision for CBS acquisition “to become premier globally branded content provider” are a few examples. But customers do not have to get it: Sears & Dean Witter Reynold/Coldwell bankers: „to deliver to customers all financial services, ranging from insurance, credit and real estate to financial instruments such as equities and commercial papers at Sears Centers under one roof with sport equipment, home appliances, flowers, car rentals and others“ October 24 2002 Synergy in Mergers & Acquisitions 20

Strategy – cont’d Two kinds of strategic synergy • Materializes without a changes in actual operations or in the manner of doing business (financial benefits, increased pricing power on both input and output side or benefits from cross-border acquisitions) • Synergy POTENTIAL There are NO purely strategic reasons, NO „perfect fit“ Harry Tempest from ABN AMRO says: “We have a rule on the Executive Committee: When someone says ‘Strategic’, the rest of us say ‘too expensive’” Defensive mergers October 24 2002 Synergy in Mergers & Acquisitions 21

Operational Implementation - detailed planning is necessary - two ways: Cost-saving („hard synergy“) redundancies – admin, production, logistics, … Revenue-enhancement („soft synergy“) cross selling, strength-strength & strength-weakness matching October 24 2002 Synergy in Mergers & Acquisitions 22

System integration can be a very significant limiting factor of many wellplanned acquisitions Examples: L Burroughs and Sperry – Unisys – 90% down L Chemical Bank and Manufacturers Hanover – 2 y Special issue – Pricing system ensure that the pricing system is CONSISTENT October 24 2002 Synergy in Mergers & Acquisitions 23

Control & culture Have become increasingly the most CRITICAL SUCCESS FACTOR in recent transactions difficult to define and control: “shared set of norms (both formal and informal), values, beliefs and expectations” or as “an interconnected composite of values, work rituals and leadership” Too aggressive culture integration doomed acquisition of Montgomery securities by Nations Bank Corp. in 1997. Less than a year and half later Montgomery securities founder Thomas Weisel left, taking 100 of his best investment bankers with him. October 24 2002 Synergy in Mergers & Acquisitions 24

Control & culture – common mistakes ØManagement withdraw and become distant ØInconsistent messages and behaviour ØCommunication disconnects from maintaining performance and focuses excessively on persuading employees to feel good ØCommunication is only top-down process ØTalented and the most perspective employees leave as they do not identify themselves with new entity ØReferral problem ØLeadership appointments – co-CEOs, … Ø …. . October 24 2002 Synergy in Mergers & Acquisitions 25

Managerial Risk Taking • Irrationality in managers’ decision-making when an M&A goes wrong - managerial hubris - risk escalation (asymmetric risk response, gamblers’ behaviour) • Difficult to empirically prove - operationalization problem (initial risk set-up, changes) - other than synergy or hubris hypothesis October 24 2002 Synergy in Mergers & Acquisitions 26

Value Estimation in M&A Decision Making – technical issues • time is crucial and can undermine even well prepared transactions if not considered • quite often underestimated of not understood MODEL: October 24 2002 for infinity Synergy in Mergers & Acquisitions 27

Value Estimation in M&A Decision Making – technical issues (cont’d) SEE GRAPHS October 24 2002 Synergy in Mergers & Acquisitions 28

Value Estimation in M&A Decision Making – technical issues (cont’d) PROBABILITY MODEL: 1. f(x) is continuous 2. 3. 4. f(0) > 0 5. f(x) is nonincreasing in x October 24 2002 Synergy in Mergers & Acquisitions 29

Value Estimation in M&A Decision Making – technical issues (cont’d) SEE GRAPHS October 24 2002 Synergy in Mergers & Acquisitions 30

Central European M&As – Macroenomic Framework • mainly unidirectional • low competitive markets with comparatively higher growth potential (situation of 1990 s) • economies-wide privatization • relatively high-skilled labor • markets for corporate control too small to be effective • synergies stemming most importantly from bridging the techgap • BUT environment specific to the MAE conditions • BUT different work attitude for historical reasons October 24 2002 Synergy in Mergers & Acquisitions 31

Central European M&As – a Case Study • two construction companies: Slovakian acquirer and Czech Target • horizontal – complementary acquisition • price paid according to market value (objective x subjective) • a few years of preceding cooperation • cultural similarity • Slovaks grabbed the opportunity October 24 2002 Synergy in Mergers & Acquisitions 32

Cornerstones of Synergy Strategy: financing, revenue enhancement Operations: joint contracts acquiring, cross-referencing joint PPE acquiring Systems: core problem – to support the above pillars management lines, ICT systems Culture: enabled by cultural affinity and preceging co-op. challenge: to make people cooperate also on lower management levels create a “Code of Joint Working” October 24 2002 Synergy in Mergers & Acquisitions 33

Outcomes L As a result of “opportunity acquisition” the change has been managed accidentally (at least in first year), looking for areas where and how to cooperate L “common sense” used in transition management, empirical evidence ignored L no clear controllable targets set J Well working referencing on top level – crucial in the business J ABOVE ALL: The acquisition is ultimately successful in terms of EAT October 24 2002 Synergy in Mergers & Acquisitions 34

Questions ? October 24 2002 Synergy in Mergers & Acquisitions 35

Thank you for attention Contact: marek. jindra@ey. cz October 24 2002 Synergy in Mergers & Acquisitions 36